APPENDIX 4
Memorandum by Centrica
EXECUTIVE SUMMARY
This winter, the gas market is tighter than
in recent years as a result of the decline in North Sea reserves.
However, we support National Grid's conclusions that even in a
severe winter, supplies to domestic customers will continue although
some major energy users with interruptible contracts may be affected.
The market is responding in anticipation of
declining UK gas supplies with new import and storage infrastructure
some of which will be available this winter. Existing storage
facilities going into the winter are all virtually full. The Rough
gas storage facility is able to deliver up to 17% of peak winter
demand and additional gas storage will be released ahead of this
winter from its "cushion" gas contained within the facility.
There is a possibility that LNG destined for
the UK may be diverted to the USA this winter where prices are
higher. In the longer term many new projects are expected to come
on line in response to the high levels of gas prices. With the
construction of new regasification terminals in North America
and elsewhere, the gas market is becoming increasingly international
and the UK will have to compete globally for future LNG supplies.
In a severe winter, power station and large
energy users may have their supplies interrupted. These customers
are fully aware of the risks associated with interruptible supplies
and will either have alternative energy sources or will adapt
their production. The majority of customers are on agreements
which mean that they can be interrupted for a maximum of 45 days.
We believe that customers on firm contracts
would only have their supplies interrupted in a very severe winter
by National Grid under their emergency plan for dealing with essential
services.
A number of uncertainties regarding the gas
supply outlook for this winter, as well as the longer term position
of the UK in terms of pricing and security of supply, relate to
the interaction between UK and continental European markets.
The effect of limited liberalisation in continental
gas markets on wholesale prices was highlighted in a recent report
by Global Insight, This costed the impact of this failure on end
consumers at as much as £10 billion in 2006. These costs
predominantly arise because the lack of liberalisation has meant
that the pricing of gas on an oil-indexed basis across continental
Europe has been maintained, isolating the level of European gas
prices from underlying supply and demand dynamics.
Lack of liberalisation is also causing distortion
in the market as evidenced by the failure of the interconnector
to respond correctly to price signals in February/March 2005.
This episode has highlighted the need for greater transparency
of information on the European market such as information about
gas flows and available pipeline capacities.
Going forward, if we are to secure the gas we
want at affordable prices it is vital that UK suppliers get access
to the continental energy networks and that markets are fully
open.
A particular concern for the longer term is
the lack of effective open access to the German gas pipeline network
through which all Russian gas would have to pass to reach the
UK. The position has been reinforced by the recent deal between
Russia and Germany by which a major new pipeline, essential for
bringing gas from the East will now bypass Poland to go direct
to Germany through the Baltic Sea.
It is therefore essential that the UK Government
keeps pressing the European Commission and other Member States
to ensure effective implementation of the Energy Market Directives
throughout the EU. This means that all Member Sates must implement
the Directives in a way that achieves the agreed objective of
a fully functioning internal market.
INTRODUCTION TO
CENTRICA
Centrica plc was formed in 1997 when the former
British Gas plc was demerged to form BG Group and Centrica. In
the UK, it trades under its brand names, British Gas, Scottish
Gas and Nwy Prydain. It is the UK's largest energy supplier, supplying
around 11 million gas and six million electricity customers in
the domestic sector and around 900,000 in the Industrial and Commercial
sector.
To support its supply businesses, Centrica owns
both gas and electricity production assets. In the UK, a significant
but declining proportion is secured through our own reserves,
chiefly the Morecambe gas field. The company has also invested
around £1.4 billion in the UKCS with interests in 28 producing,
development, storage or exploration fields in the UK sector.
Over the past three years, Centrica has further
committed over £12 billion to contracts for new international
gas supplies, helping underpin two new pipeline projects, BBL
and Langeled, and one new LNG facility at Milford Haven. Two long-term
gas contracts with Statoil and Gasunie will deliver 10% of future
UK gas supplies. The company has also announced a contract with
Petronas in Malaysia to bring LNG to the UK. In addition, Centrica
has made a long-term capacity booking in the second phase of the
Isle of Grain LNG import terminal and is part of a consortium
seeking to develop a further LNG import terminal on Canvey Island.
Centrica's subsidiary, Centrica Storage Limited
(CSL) operates Rough, one of the largest gas storage facilities
in Europe. CSL is a separated business unit operating with "chinese
walls" between and limited contact with other parts of Centrica.
Renewable energy is also playing an increasingly
important role in Centrica's energy portfolio both to deliver
diversity of supply and to reduce the UK's carbon emissions. To
date, the company has committed £750 million in developing
both offshore and onshore windfarms.
1. Energy market overview
1.1 Secure energy supplies are vital to
both domestic and non-domestic consumers. Centrica's view is that
security of supply is best maintained through efficient and appropriate
regulation of networks and properly functioning wholesale and
retail energy markets. This has served British consumers well
by delivering supplies at a reasonable cost.
1.2 The market is delivering considerable
investment in sourcing new gas supplies. For example, Centrica
alone has committed £12 billion to long-term gas procurement
contracts with Gasunie, Statoil and Petronas. In power, there
are currently consents for three new large-scale power stations,
including our own project at Langage, whilst other mothballed
power stations are being brought back on stream.
1.3 Since privatisation in 1986 and the
start of liberalisation in the early 1990s, over 15 billion has
been invested in the gas network—a much higher amount than
before privatisation. Proposals are also being put forward which
will increase the amount of gas storage available to help meet
peak winter demand.
1.4 Diversity of gas supply and transport
routes is another important factor in ensuring security of supply.
As North Sea supplies of gas decline, the UK is increasingly dependent
on importing gas from further afield. Some of this gas will come
in Liquefied Natural Gas (LNG) and be imported into purpose-built
terminals. Gas will be also imported through the interconnector
pipelines from Belgium, The Netherlands and Norway. The diagram
below shows the range of infrastructure to bring new imports to
the UK.
1.5 With gas accounting for 33% of British
electricity generating capacity, there is a clear interaction
between the gas and electricity markets. Electricity plant margins
are currently around 21% (ie available capacity exceeds expected
peak winter demand by 21%) which is still within the acceptable
margin band supported by National Grid. For the purpose of this
submission, we will be focusing on gas supply.
1.6 As the UK becomes increasingly dependent
on international sources of gas, effective liberalisation of the
gas and electricity markets in continental Europe is essential
to deliver greater security and competitive pricing of gas supplies
to the UK. The priority for the European Commission must be to
ensure that markets are fully opened and access to networks is
granted to third parties on equal terms to incumbent suppliers
(including Transmission System Operator affiliates).
2. Gas supply/demand & Winter Outlook
2005-06
2.1 This winter, the gas market is tighter
than in recent years. North Sea gas supplies are declining and
the UK is now a net importer of gas. However, we support National
Grid's conclusion that even in a severe winter, supplies to domestic
customers will continue although some major energy users with
interruptible contracts may be affected.
2.2 The market has already responded in
anticipation of declining UK gas supplies with new import and
storage infrastructure, some of which will be available this winter.
Capacity in the existing interconnector pipeline from Zeebrugge
in Belgium has been doubled enabling it to import more gas from
continental Europe and the first phase of capacity at the Isle
of Grain LNG terminal is also ready to receive imports. Recently
Centrica's £4 billion contract with Statoil in Norway has
started delivering gas to the UK.
2.3 Existing gas storage facilities going
into the winter are all virtually full and new storage facilities
are being built. The Rough Storage facility has achieved record
deliverability in the first half of 2005, increasing its peak
capability by 7%. Besides having record levels (117bcf) of gas
in store ahead of the winter, Centrica Storage Limited has also
announced recently that it is releasing additional gas storage
from its "cushion" gas contained within the facility.
The additional gas equates to supplying around 65,000 homes over
52 peak days of winter (this is over and above Rough meeting 10%
of UK peak gas demand from its normal storage capacity) and clearly
comes at a time when any additional storage capacity will be very
beneficial.
2.4 Centrica has been maximising supplies
from its own operations. We have discovered some additional gas
as part of our drilling programme in the South Morecambe field.
We have also preserved supplies by deferring a high proportion
of production for the winter peak period.
2.5 Our long-term contract with Shell, Exxon
and BP in the Sean field is specifically designed for peak winter
use to meet domestic customer demand requirements in the coldest
periods of the winter. The field can supply up to 3% of peak winter
demand.
2.6 Despite all this investment, there are,
however, a number of uncertainties that could affect the gas supply/demand
balance this winter. These relate to the interconnector import
flows, diversion of LNG to the USA and the weather. These are
addressed in more detail in the following sections.
3. INTERCONNECTOR
IMPORT FLOWS
3.1 The events of late February/March 2005
when gas did not flow in response to high UK prices has raised
concerns that the interconnector may not deliver sufficient volumes
of gas to the UK when required.
3.2 As the graph below shows, last February
UK prices rose to nearly 120p/therm against the 30p contract price
in Europe. However, little gas flowed to the UK. A contributory
factor was undoubtedly severe winter weather in parts of North
West Continental Europe. Winter 2004-05 also saw major supply
reductions from Libya to Italy and Russia to Europe causing heavy
storage stock reductions on Europe. However, the incident also
highlighted that the Continental gas markets do not respond to
price signals in a way that would be normal in a liberalised competitive
market.
3.3 A key issue is the lack of transparency
in much of the EU market. Unlike the UK market, there is frequently
no real time information about gas flows and available pipeline
capacities. As a result, the UK is left guessing as to the precise
reasons why observed gas flows have diverged from expected market
behaviour.
4. LNG IMPORTS
4.1 As the Trade and Industry Select Committee
press release highlights, a further uncertainty is the amount
of LNG that may be diverted to the USA this winter.
4.2 Unlike pipeline deliveries, LNG vessels
have some flexibility and can be redirected to other receiving
terminals around the world, attracted to where the price is highest.
Current US wholesale gas prices this winter are very high in part
due to shortage of supply as a consequence of Hurricane Katrina.
This is creating some commercial incentive for gas exporters to
divert cargoes to the USA. There are, however, a number of practical
constraints on the extent of such diversion including contractual
restrictions that preclude diversion.
5. WEATHER
5.1 The supply/demand outlook for this winter
is heavily dependent on the severity or otherwise of the weather.
National Grid's assessment of supply security in a "severe
year" (1 in 50) uses 76 years of weather/demand data. It
is interesting to note, for example, that the last severe 1 in
50 winter was in 1963. In fact, evidence seems to suggest that
winters have been getting warmer with eight of the last 10 winters
being warmer than average whilst seven of the 14 warmest winters
since 1928-29 have occurred in the last 10 years.
5.2 The UK Metrological Office has made
a number of predictions of a colder than average winter this winter,
assigning a 66% probability. However, even if the UK has a colder
winter than 1995-96 which the Metrological Office is predicting,
this is still significantly milder than the 1 in 10 winter referred
to in the National Grid conclusions.
6. INTERRUPTIBLE
SUPPLIES
6.1 In the event of a severe winter, it
is essential that domestic supplies are maintained. Consequently,
there are a number of demand side responses that can be used by
Centrica through contractual rights to interrupt delivery of gas
supplies to a number of larger gas customers.
6.2 These typically apply to power stations
and the largest energy users who benefit from a discount to compensate
for the possibility of interruption. Such interruptible customers
pay between 3-12% less than equivalent firm (ie non interruptible)
customers, depending on the total days of interruption accepted.
6.3 In the event of an interruption, power
stations, including several of our own, have the facility to switch
to an alternative fuel, chiefly to oil. Alternatively they are
able to seek replacement gas in the gas market. For larger energy
customers, who are fully aware of the risks associated with interruptible
supplies, they will either have alternative energy sources or
will adapt their production accordingly. The majority of customers
are on agreements which mean that they can be interrupted for
a maximum of 45 days.
6.4 Centrica have a small number of customers
on interruptible contracts. All customers have annual interruptible
briefing meetings and we update our interruptible contact base
on an annual basis so that when we are given notice by National
Grid to interrupt we can notify our customers as quickly as possible.
6.5 We believe that customers on firm contracts
would only have their supplies interrupted in a very severe winter
by National Grid under their emergency procedures which includes
an emergency plan for dealing with essential services.
7. IMPACT ON
WHOLESALE PRICES
7.1 Inevitably, the tightness of supply
and demand is contributing to high wholesale gas prices. For the
coming winter, forward prices are 58p/therm compared to 43.2p/therm
at the same period last year, an increase of 34%.
7.2 We also estimate that the lack of liquidity
in the market with fewer traders prepared to sell forward is adding
to the upward price pressure and contributing to an "anxiety
premium" in future wholesale gas price levels. In particular,
Q1 2006 prices still appear to us to be higher than is justified
by the fundamental supply/demand outlook.
7.3 Limited liberalisation in Continental
gas markets is also having an affect on UK wholesale prices. A
recent study by Global Insight costed the impact of this failure
on end consumers at as much as £10 billion in 2006. These
costs predominantly arise because the lack of liberalisation has
meant that the pricing of gas on an oil-indexed basis across continental
Europe has been maintained, isolating the level of European gas
prices from underlying supply and demand dynamics.
7.4 The research also found that the level
of premium (anxiety or risk premium) in the forward market was
somewhere around 20p/therm in August when the report was written.
While not all of this premium can be put down to the interaction
with Europe, even 1p/therm due to this would add £200 million
in costs to energy users in the UK over next winter
7.5 Going forward, if we are to secure the
gas we want at affordable prices, then it is vital that UK suppliers
get access to the Continental energy networks and that markets
are fully opened—see section 10 below.
8. IMPACT ON
DOMESTIC CONSUMERS
8.1 Domestic and business consumers are
seeing high wholesale prices feeding through to their energy bills.
In line with other energy suppliers, British Gas announced in
September of this year that it was increasing gas and electricity
prices by 14.2%. Even factoring this increase, UK domestic prices
are still 17% cheaper than France and 40% cheaper than in Germany.
8.2 The increases are significant for all
customers, but particularly those vulnerable customers least able
to pay their energy bills. To mitigate the impact of the rise,
British Gas announced a rebate of up to £60 for 250,000 of
its most vulnerable customers which will offset the increase.
This is the largest social initiative of any energy supplier and
is in addition to a £10 million Energy Trust Fund and our
"here to HELP" programme. "here to HELP" aims
to alleviate household poverty by targeting 500,000 homes with
a range of benefits including free energy efficiency measures
and charity support. British Gas has recently extended the reach
of the scheme to cover one million homes
8.3 As energy prices rise, more people are
pushed into fuel poverty, making the Government's target to eradicate
fuel poverty amongst vulnerable groups by 2010 and all groups
by 2020 all the more difficult.
8.4 Low energy prices have been one of the
key factors in reducing the levels of fuel poverty from four million
in 1996 to 1.75 million in 2002. The Fuel Poverty Action Group
(FPAG) warn that a 10% increase in prices pushes an extra 400,000
people into fuel poverty.
8.5 However, fuel poverty is a complex interaction
of income, housing quality, energy prices and consumption in the
long-term. Reductions in the number of fuel poor can not be sustained
by energy prices alone Government, industry and all stakeholders
need to work together to address the root causes of fuel poverty
and to ensure that the money available is targeted at the most
needy.
9. IMPACT ON
MAJOR ENERGY
USERS
9.1 The current fluctuation in wholesale
prices is having a significant impact on major energy users who
are more directly exposed to the patterns of the wholesale curve.
However, there is evidence that prices are increasing in Europe
too. Germany has recently seen increases in the region of 10%
and further increases are expected next year. Norsk Hydro is reported
to be planning to close an Aluminium smelter plant in Germany
as a result of the price increases. As European prices increase,
and there is often a lag of between three and nine months for
price increases on the Continent to pass through to consumers,
this should reduce the competitive disadvantage experienced by
a number of UK companies.
9.2 It is worth noting though that for smaller
industrial users, prices in the UK are lower than in several major
Continental markets. According to recent figures from Eurostat
corresponding to the 1 January 2005, average UK prices for such
customers are 5% lower than the EU average, 25% lower than the
German average and 7% lower than the French average.
10. EU ENERGY
LIBERALISATION
10.1 A number of uncertainties regarding
the gas supply outlook for this winter, as well as the longer-term
position of the UK in terms of gas pricing and security of supply,
relate to the interaction between UK and continental European
markets.
10.2 With the UK now a net importer of gas
and to an increasing extent dependent on international supplies,
it is essential that there are no obstacles to the free flow of
gas across continental Europe to the UK on fair and reasonable
terms and, that companies such as Centrica are able to buy this
gas in a liberalised EU market. If not, UK security of supply
could be put in jeopardy and UK consumers will continue to pay
more for their energy.
10.3 The EU has a clear timetable for liberalising
energy markets, which should already include all business customers
across the community and which will extend to household competition
by 2007. However, the continued reluctance of some Member States
to open up their energy markets effectively is to the detriment
of UK businesses and customers.
10.4 Increasingly there is evidence of energy
company consolidation and the creation of favoured "national
champions" on the continent, even before energy markets have
liberalised. The most recent example is the proposed merger between
Gas Natural and Endesa in Spain. Such deals often have the support
of national Governments but their impact is to foreclose effective
competition even before markets have been effectively liberalised.
10.5 A particular concern for the longer-term,
is the lack of effective open access to the German gas pipeline
network, through which all Russian gas would have to pass to reach
the UK. This position has been reinforced by the recent deal between
Russia and Germany by which a major new pipeline, essential for
bringing gas from the East, will now bypass Poland to go direct
to Germany through the Baltic Sea.
10.6 It is therefore essential that the
UK Government keeps pressing the European Commission and other
Member States to ensure effective implementation of the Energy
Market Directives throughout the EU. This means that all Member
States must implement the Directives in a way that achieves the
agreed objective of a fully functioning internal market.
10.7 Member States need to do more to provide
real third party access to gas pipeline networks and gas storage
on the same terms as incumbents, confidence that network-operator
unbundling is preventing discriminatory conduct, full transparency
of the market and a regime that encourages investment.
10.8 The Commission must also be encouraged
to take prompt action to address anti-competitive behaviour, under
the ongoing sector inquiry into the gas and electricity market.
11. FUTURE OUTLOOK
BEYOND 2006
11.1 As new import infrastructure comes
on-line, the pressure on UK security of supply will be reduced
and Centrica would expect downward pressure on prices, especially
from 2007-08 onwards. The Langeled pipeline running from Norway
to Easington is due to be completed in 2007 and the BBL pipeline
from the Netherlands to Bacton in the UK will be completed in
2008. Additional capacity in the Interconnector UK from 2006 will
also increase the potential amount of gas to the UK.
11.2 LNG provides important diversity of
gas supply sources for Europe, since it provides a way of transporting
gas economically over longer distances. Currently the UK has only
limited LNG import capacity at 4% of total supplies compared to
63% in Spain and 21% in France. With the construction of new terminals
at the Isle of Grain and Milford Haven and the conversion of the
LPG facility at Canvey Island this should increase to an estimated
20% by the end of the decade.
11.3 Although global LNG supplies are expected
to be tight over the next few years, there are many new LNG projects
under development (eg Nigeria, Qatar). Large scale liquefaction
trains and bigger ships mean that the economics of supplying LNG
have improved. Many new projects are expected to come on line
in response to the high levels of gas prices, particularly in
the US. With the construction of new regasification terminals
in North America and elsewhere, the gas market is becoming increasingly
international and the UK will have to compete globally for future
LNG supplies.
11.4 The UK has lower levels of storage
capacity relative to the rest of Europe. Over the next five years
if planned constructions delivered the UK should double its current
capacity. Access to European storage will also be important going
forward.
October 2005
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